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Carry Trade and Liquidity Risk: Evidence from Forward and Cross-Currency Swap Markets

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Abstract

This study empirically examines the effect of foreign exchange (FX) market liquidity risk and volatility on the excess returns of currency carry trades. In contrast to the existent literature, we construct an alternative proxy of liquidity risk - violations of no arbitrage bounds in the forward and currency swap markets. We also use volatility smile data to capture FX-market specific volatility. The sample data cover periods both before and after the Global Financial Crisis (GFC). Both proxies are significant in explaining the abnormal returns of carry trades, particularly after the GFC. Our findings provide substantial evidence that uncovered interest parity (UIP) puzzle can be resolved after controlling for liquidity risk and market volatility.

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File URL: http://www.qfrc.uts.edu.au/research/research_papers/rp310.pdf
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Bibliographic Info

Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 310.

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Length: 35
Date of creation: 01 Aug 2012
Date of revision:
Handle: RePEc:uts:rpaper:310

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Keywords: uncovered interest rate parity; carry trade; liquidity risk; no-arbitrage bound; volatility;

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  1. Patrick McGuire & Goetz von Peter, 2009. "The US dollar shortage in global banking," BIS Quarterly Review, Bank for International Settlements, March.
  2. Lasse Heje Pedersen & Mark Mitchell & Todd Pulvino, 2007. "Slow Moving Capital," American Economic Review, American Economic Association, vol. 97(2), pages 215-220, May.
  3. Charlotte Christiansen & Angelo Ranaldo & Paul Söderlind, 2010. "The Time-Varying Systematic Risk of Carry Trade Strategies," Working Papers 2010-01, Swiss National Bank.
  4. Hanno Lustig & Adrien Verdelhan, 2006. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk," Boston University - Department of Economics - Working Papers Series WP2006-045, Boston University - Department of Economics.
  5. A. Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio T. Rebelo, 2010. "Do Peso Problems Explain the Returns to the Carry Trade?," Working Papers 10-44, Duke University, Department of Economics.
  6. Lasse Heje Pederson & Markus K Brunnermeier, 2007. "Market Liquidity and Funding Liquidity," FMG Discussion Papers dp580, Financial Markets Group.
  7. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2009. "Carry Trades and Currency Crashes," NBER Chapters, in: NBER Macroeconomics Annual 2008, Volume 23, pages 313-347 National Bureau of Economic Research, Inc.
  8. Angelo Ranaldo & Paul Söderlind, 2007. "Safe Haven Currencies," University of St. Gallen Department of Economics working paper series 2007 2007-22, Department of Economics, University of St. Gallen.
  9. Andrei Shleifer ad Robert W. Vishny, 1995. "The Limits of Arbitrage," Harvard Institute of Economic Research Working Papers 1725, Harvard - Institute of Economic Research.
  10. Naohiko Baba & Frank Packer & Teppei Nagano, 2008. "The spillover of money market turbulence to FX swap and cross-currency swap markets," BIS Quarterly Review, Bank for International Settlements, March.
  11. Markus K Brunnermeier, 2002. "Bubbles and Crashes," FMG Discussion Papers dp401, Financial Markets Group.
  12. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
  13. Craig Burnside, 2007. "The Forward Premium is Still a Puzzle," NBER Working Papers 13129, National Bureau of Economic Research, Inc.
  14. Ingo Fender & Patrick McGuire, 2010. "European banks' US dollar funding pressures," BIS Quarterly Review, Bank for International Settlements, June.
  15. Baba, Naohiko & Packer, Frank, 2009. "From turmoil to crisis: Dislocations in the FX swap market before and after the failure of Lehman Brothers," Journal of International Money and Finance, Elsevier, vol. 28(8), pages 1350-1374, December.
  16. Naohiko Baba & Frank Packer, 2009. "From turmoil to crisis: dislocations in the FX swap market before and after the failure of Lehman Brothers," BIS Working Papers 285, Bank for International Settlements.
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